Receivable Management
Learning Objectives:
1. Understand the concept of accounts receivable management
2. Explain the credit selection process and the quantitative selection process and the quantitative procedure for evaluating
changes in credit standards
3. Review the procedures for quantitatively considering cash discount changes, other aspects of credit terms and credit
monitoring
Introduction
The average collection period has two parts:
1. The time from the sale until the customer mails the payment
2. The time from when the payment is mailed until the firm has the collected funds in its bank account
- Managerial control requires proper management of liquid assets and inventory. These assets are a part of working capital
of the business.
- An efficient use of financial resources is necessary to avoid financial distress.
- Receivables constitute a significant portion of current assets of a firm.
- Investment of funds in accounts receivables involves a trade-off between profitability and risk.
Accounts Receivable Management
- The objective for managing accounts receivable is to collect accounts receivable as quickly as possible without losing
sales from high-pressure collection techniques.
- Accomplishing this goal encompasses three topics:
1. Credit selection and standards
2. Credit terms
3. Credit monitoring
Elements of Credit Policy
1. Credit Period
- The length of time buyers has before they must pay for their purchases
2. Cash purchases discount
- The reduction in price to encourage prompt payment
3. Credit standards
- The minimum financial strength of acceptable credit customers
4. Collection policy
- Reflects the firm’s toughness or laxity in following up on slow moving or slow paying accounts
Costs of Maintaining Receivables
1. Cost of Financing Receivables
- The receivables are financed from the funds supplied by shareholders for long-term financing and through retained
earnings.
2. Cost of Collection
- The customers who do not pay the money during a stipulated credit period are sent reminders for early payments.
- Some persons may have to be sent for collecting these amounts.
3. Bad Debts
- Some customers may fail to pay the amounts due from them.
- The amounts which the customers fail to pay are known as bad debts.
Credit Selection and Standards (5 Cs)
1. Character
- The applicant’s past record of meeting financial, contractual and moral obligations
2. Capacity
- The applicant’s ability to repay the requested credit amount
- This is evaluated through financial statement analysis particularly liquidity and debt ratios
3. Capital
- The applicant’s financial strength, measured by ownership position (percentage equity) and profitability ratios
4. Collateral
- The assets available to secure the applicant’s credit
5. Conditions
- The current economic and business environment, as well as any special circumstances, affecting either party to the credit
transaction
Credit Scoring
- A credit selection method commonly used with high-volume/small-amount credit requests
- Relies on a credit score determined by applying statistically derived weights to a credit applicant’s scores on key
financial and credit characteristics
Credit Terms
- The terms of sale for customers who have been extended credit by the firm
Cash Discount
- A percentage deduction from the purchase price
- Available to the credit customer who pays its account within a specified time
Credit Monitoring
- It is the ongoing review of a firm’s accounts receivable to determine whether customers are paying according to the
stated credit terms.
Aging Schedule
- A credit-monitoring technique that breaks down accounts receivable into groups based on their time of origin
Credit Policy
- If a firm’s credit policy is eased by such actions as lengthening the credit period, relaxing credit standards, following a
less tough collection policy or offering cash discounts, sales will increase.
- Easing the credit policy normally stimulates sales.
- If credit policy is eased and sales do rise, some related costs will also rise due to the following situations:
1. The more labor, materials and other operating costs are required to produce the additional goods
2. That receivables outstanding will increase, thus, carrying cost of accounts receivables will likewise increase
3. That risk of uncollectibility or bad debt will be greater and discount expenses may also rise
Credit policies that are integral part of the entire credit cycle
1. Trade Discount
- Cash discount can expedite the collection of receivables.
- The concern will be able to use the additional funds received from expedited collections due to cash discount.
2. Discount Time
- The collection of receivables is influenced by the period allowed for availing the discount.
- The additional period allowed for this facility may prompt some more customers to avail discount and make payments.
3. Credit Period
- Credit terms or length of credit period means the period allowed to the customers for making the payment.
- The customers paying well in time may also be allowed certain cash discount.
4. Credit Limit
- A finance manager should match the increased revenue with additional costs.
- The credit should be liberalized only to the level where incremental revenue matches the additional costs.
Factors affecting the level of receivables:
1. Type of products or services
2. Existing terms with own suppliers
3. Variation of sales peak and slack seasons
4. Reputation to extend credit terms
5. Existing credits terms offered by competitors
6. Size of the company
Flexibility
- For each business, extending credit is always the name of the game.
- Every firm must evaluate their own credit policies (update policies) to be able to make some adjustments that are to be
more liberal or to be stricter.
Things and other terms to note in management of receivables:
1. Care should be taken in setting credit policies.
2. Approval of payment terms (terms of sale) to ensure that terms do not result increased receivables without a
corresponding increase in sales volume and profitability.
3. Prepare and bill customers on same day of shipment.
4. If collection management is efficient, collection is faster, receivable turnover is higher and collection period is shorter.
5. Collections
- More effort should be devoted on past due accounts especially balances with large amounts
6. Turnover of collection to authorized person by a field collector must be done daily to prevent lapping of collections.
7. The Provisional Receipts or Official Receipts must likewise be countersigned and dated by the cashier or the authorized
person receiving the collections.
8. Discount Time
- Depends on the industry practice, competition, operating cycle, financial capacity of the seller and long-term objectives
of the company
- If the discount time is short, collection is accelerated
- A change in the discount time also changes the effective discount rate
9. Credit Period
- Refers to the entire credit days granted to customers
- A long credit period slows down collection
10. Credit Cap
- The limitation of credit time in terms of amount set or imposed by the seller to a given customer depending on his
capacity to meet trade payments
- The higher the credit risk of a customer, the lower the credit cap is
11. Credit Block
- The policy of non-delivery of merchandise to customer once their accounts become past due
- New deliveries will be made once an account has been collected or becomes current
12. Credit Class
- Pertains to the group of customers to whom merchandise shall be delivered
- Customers are classified according to income level, place of residence, gender, age, geographical location, civil status
- Credit limits and other credit terms are determined for each credit class
13. Changes in Credit Policy
- Compute the increase or decrease in sales, variable costs, contribution margin, accounts receivable, doubtful accounts
expense and collection.
14. Changes in Collection Policy
- Determine the change in collection period, accounts receivable turnover, accounts receivable balance and increase on
collection costs.
15. Receivable Portfolio Analysis
- It refers to the strategy of spreading investments in receivables over a customer base.
- Receivables must be tracked down per customer group, age and customer balances in order in order to speed up
collections.
